All that jitters does not fold
Way back when the home market was still rising with no apparent end in sight, I used defaults in subprime lending as the miner’s canary,
For housing markets, forecasting is notoriously difficult. Prices are extremely complex, interdependent, multi-variant, and phase-delayed (with larger and smaller economic forces having both leading and trailing effects).
Waves upon waves upon waves …
One day existing home sales are down (doom!), literally the next new home sales are up (cheer!).
Out of all that apparent chaos, how does one prospectively determine major trends? (Anybody can determine them retrospectively, but that’s very cold consolation.)
Larry Niven: “Any damn fool can predict the past.”
Enter the miner’s canary — the sensitive universal leading indicator. Why is subprime lending a leading indicator? Because by definition, subprime borrowers are at the edge of the bankable frontier (as my AHI colleague David Porteous has discussed on his blog), and as such, they are the most sensitive to changing economic circumstances:
Most high-rate mortgages, known as subprime loans, have adjustable interest rates, Fitch said. That means borrowers are more sensitive to fluctuations in rates, because rising rates mean their mortgage payments rise as well.
You might think the link between subprime and adjustable rates a coincidence, but reflect for a moment — people at the bankable frontier are trying their hardest to stretch their limited dollars into a purchase. When the yield curve is positive — which is the normal state of things — the lowest interest rate is to be had if it is variable. So the same feature that drives someone to a subprime lender also motivates that borrower to choose a variable rate loan when she arrives.
Note the obvious: subprime delinquency rates lead normal market rates. You might think that subprime borrowers, having managed to leap onto the rising economic ladder of homeownership, could rapidly pull themselves up. Economic reality is more cruel; while many do, quite a few don’t.
Fifteen months later, the Wall Street Journal is showing that subprime lending was not simply a harbinger of overall market performance, but also a wobbly sector in itself:
No credit worries here
Default worries are growing at the risky end of the mortgage market.
Those worries sent some home lenders’ shares plunging yesterday and highlighted uncertainties about how many investors in mortgage-backed securities might be vulnerable.
In an efficient capital market, originators like subprime lenders then sell their paper, often via securitization. Wikipedia’s pretty-good definitions:
Securitization is the process of homogenizing and packaging financial instruments into a new fungible one. Acquisition, classification, collateralization, composition, pooling and distribution are functions within this process [1]
Securitization is the packaging of designated pools of loans or receivables with an appropriate level of credit enhancement and the redistribution of these packages to investors. Investors buy the repackaged assets in the form of securities or loans which are collateralized (secured) on the underlying pool and its associated income stream. Securitization thereby converts illiquid assets into liquid assets.[2]
Without delving too deeply into the details [Have patience, dear readers: Sherlock Holmes will discourse on securitization in a future post. — Ed.], in a securitization the originator keeps the junior piece and thus takes the first loss, whereas the investors take the senior piece. So ordinarily the investors would be safe, unless their junior holder/ originator suddenly found itself in financial trouble.
Did someone say, “financial trouble?”
New Century Financial Corp. shares dropped $10.92, or 36%, to $19.24 in
New Century is one of the nation’s biggest specialists in “subprime” mortgage loans, or home loans for borrowers with weak credit histories. The company blamed its woes on “the increasing industry trend of early-payment defaults,” those that occur within the first few months after a loan is made.
When faced with an unpleasantness, resort to euphemism, for it clouds the ugly reality so nicely.
Good thing we can’t see how dangerous it is
“Early-payment default” means that very, very shortly after receiving a loan, the borrower misses a payment. A very discouraging sign. One might even suggest it is a symptom of bad, slapdash, or downright crooked underwriting.
Shares of other subprime lenders, including Fremont General Corp. and NovaStar Financial Inc., also plummeted. The combined market value of seven U.S.-based lenders active in the subprime market dropped more than $3.7 billion yesterday.
Evidently the capital markets also think subprime lending is a miner’s canary.
Contributing to the selloff was an announcement, late Wednesday, by British banking giant HSBC Holdings PLC that problems in its subprime-mortgage business were worse than previously indicated. Yesterday, shares of HSBC, whose operations extend well beyond the subprime sector, fell $2.44, or 2.7%, to $89.78 in
In an interdependent ecosystem, a major shock in any sector has ripple aftershocks in other sectors. In larger policy terms, that’s good because it distributes risk and cost across the whole financial network.
For now, most people in the $10 trillion
The trader’s trader
But for those in line for the shocks, it’s bad.
Many in the industry are wondering how well investors in mortgage-backed securities will cope as delinquencies rise. Lenders quickly sell most subprime mortgage loans to packagers of securities, such as investments banks, or directly to investors.
Paging Sherlock Holmes for the securitization primer! The critical point here is that although the originator takes first loss (top loss position), if the originator’s capital or risk tolerance is exhausted, then the security holders also take losses.
There are some top losses we just shouldn’t take, now should we?
Actually, it’s worse than that, for so hungry is the market for investments that some people are buying the dross:
The riskiest of those securities, those that absorb some of the first losses from defaults, are typically sold to money managers and hedge funds in the
Yikes! Who takes first loss exposure without control?
“The thing none of us know, including the [Federal Reserve], is who is holding this stuff,” Richard Kovacevich, chief executive of Wells Fargo & Co., one of the nation’s biggest mortgage lenders, said in a recent interview.
Kovacevich wants to know who’s holding the stuff
A yield hog, that’s who.
“The assumption is that it is well-diversified. If it’s concentrated, it’s going to be a disaster.”
In other words, somebody who bought only one strip of the security is very exposed.
Something I should worry about?
The number and variety of investors in
By packaging loans into securities, lenders can spread their risk and issue more loans than they might otherwise. But they aren’t fully insulated. Investors have been forcing lenders to buy back many dud loans, creating a sudden financial burden that has led to the closure of several smaller subprime lenders in the past two months.
You might think caveat emptor when it comes to packages of securities, but in the high-stakes world of traders, people make representations (written or verbal) to one another about the quality of securities; and the buyers rely on those statements. Thus it’s reasonably common for there to be put-back rights on some fraction of some pools, so in effect the originator is exposed even beyond the piece it has retained.
A report issued by Credit Suisse on Wednesday found that nearly one in four subprime mortgage deals issued in 2006 had a delinquency rate of at least 8% as of December. The analysis looked at loans that were at least 60 days past due.
Now, that in turn requires the subprime mortgagees to be getting interest rates at least 13/12ths of those they have to pay. So if they’ve sold securities at (say) 6.0%, they need to collect 6.5% from performing borrowers to compensate for the defaults. That sounds plausible.
Until about three years ago, two
And, as we saw in previous posts, made very nice spread for so doing.
But, as Fannie and Freddie found themselves hobbled by accounting scandals, other investors flooded into the market, snapping up loans that the two companies otherwise might have bought.
The bigger fool?
Will I ever find a buyer for my securities?
As a result, the two companies’ share of the market has plunged to about 40% at the end of last year from 70% in 2003, according to Inside Mortgage Finance, a trade publication.
When Fannie and Freddie dominated the market, Mr. Ranieri says, they generally set the standards for what types of loans would be made. Now, those standards are largely set by the risk appetites of thousands of hedge funds, pension funds and other money managers around the world. Emboldened by good returns on mortgage investments, they have encouraged lenders to experiment with a profusion of loans.
In other words, if you can sell the riskiest piece (called in the trade the B or C piece), you can certainly sell the safer security (called the A piece), and therefore originate the loan.
Many subprime borrowers aren’t required to prove their financial health with tax forms or other documents.
This sets up agency risk between originator and securities purchaser.
Lenders also sometimes rely on computer programs, rather than human appraisers, to estimate the value of homes.
When in doubt, guess
Less important than whether valuation is human or automated is that the last decade’s benign financial environment has desensitized the marketplace to risk.
The housing boom of recent years held defaults to very low levels because borrowers who fell behind on payments could easily sell their homes or refinance into a loan with easier terms. But as house prices have flattened or dipped in many parts of the country, far more borrowers are falling behind.
Loan repayment is predicated on two things: borrower ability to pay, and recoverability of the collateral. In a rising-price environment, the collateral insulates everybody. When prices fall, it’s not so much that more borrowers give up, as that when they do, the lender takes a loss.
Another innovation of recent years — the collateralized debt obligation, or CDO — has made it possible for far more investors to make bets on
That diversification lowers risk. But if the Journal is to be believed, investors compensated by taking more individual risk, climb farther out on the credit limb.
Safe as houses
CDOs buy the bulk of the lower-rated rungs of subprime-mortgage securities, those that take some of the first hits if defaults are higher than expected, says Kedran Garrison, a CDO analyst at J.P. Morgan Chase & Co.
So you’re aggregating B pieces.
CDOs are especially attractive to investors in Europe and Asia, as well as many in the
Yes, no matter how many times one passes the Old Maid, sooner or later somebody takes a big loss.
I’ll just take the most junior tranche
That could be a problem for regulators. In 1998, the Fed convened investment banks and worked out a rescue plan for hedge fund Long Term Capital Management LP, which was on the verge of collapse. But in today’s splintered mortgage-securities market, the Fed wouldn’t be able to “get the involved players into a room” to work out a plan to help a distressed institution sell off assets in an orderly manner, says Josh Rosner, managing director of Graham Fisher & Co., a New York investment research firm.
Yes, except that the holders would be diversified and the risk spread out.
A spokeswoman for the Fed declined to comment.
What is there to say?
